So there we are; back after a long weekend with the weather patterns to match, which in turn offered up a bit more reading time than had been anticipated. I’m not sure I recognise the same glowing outcome of the first 100 days of the Trump presidency that he himself does and although he might have taken on more business in that period than many, if not most, of his predecessors, meaningful results are few and far between. And then came the one financial markets had been waiting for but, in true Trump style, it was not at all what folks had been expecting.
Sure, the break-up of the banks, the newest big idea to come from the administration, had been mooted but the execution risk is nearly as big as that of the intended repeal of Obamacare.
Breaking the banks into investment banking and commercial banking businesses, effectively a re-introduction of the Glass-Steagall Act of 1933, may look easy but it is not at all. I lived through the piecemeal disassembly of the law and, to be frank, I was never a great fan of its being done. Let me explain.
The asset price bubble of 1927-1929 was prompted by the distribution of product directly to a public which did not understand what it was buying. Glass-Steagall was to have two effects. The first was to limit the ability of banks to sell stock directly to petty retail until it had traded in the wholesale market for long enough for manipulated pricing to be flushed out. Secondly, splitting the brokers from the banks and banning the banks from fiddling in stocks and corporate bonds, it assured that balance sheet capital could not be used to artificially support such false prices.
The theory was that if the investment bank or broker was short of capital, then holding a mispriced position would block future business thus forcing the price of the security to be brought into equilibrium as soon as possible in order for it to be cleared off the books. By prohibiting immediate distribution to the unsophisticated investor - that’s “petty retail” to you and me - Joe SixPack could rest assured that he was going have his eyes ripped out quite as ruthlessly as had happened in the past.
Jump forward 50 years to the run-up to Big Bang in 1987. I was at Barclays at the time Barclays Merchant Bank, the stock broker de Zoete Bevan and the jobber Wedd Durlacher were melded into BZW, the precursor to Barclays Capital, now Barclays Investment Bank. This is thirty years ago and yet even then, as a young and thrusting thirty-something, I disliked the idea of commercial bankers trying to be investment bankers as much as I feared what might happen if investment bankers got a grip on the power of the bank’s balance sheet.
It was back then that I first formulated the definition distinguishing the varying cultures of investment and of commercial banking. The commercial banker, I concluded, would ask of a proposed piece of business “How much can this cost me?” as opposed to the investment banker who only wondered “How much can I make?”
Please don’t get me wrong, I am not joking here. Transactional banking mixed with an excess of capital backing are the toxic mix which Glass-Steagall aimed at avoiding and which its repeal brought about. Without the ability underwrite the massive securitised transaction which came before the GFC of 2007/2008 and without the capital to retain huge first loss pieces on the balance sheet at synthetic prices, the sub-prime crisis would never have occurred or if so, certainly not in the size in which it did. Ruthless investment bankers were abusing the motherships’ balance sheets whilst the power of excess capital enabled them to paint pictures in the markets and to support illusory valuations.
But that is only one side of the equation.
Ever larger global corporations demanded ever larger banks for ever larger transactions and fee earning advisory business went to those banks which could and would offer most balance sheet at the lowest cost. Investment banks, once nimble players, took outside capital and turned themselves into leaden-footed behemoths who had to compete with the muscle power of the Citibanks, the Deutsche Banks and the BNPs of this world. Citi had incorporated the once mighty Salomon Brothers, Deutsche owned Bankers Trust and BNP swallowed up Paribas as capital trumped skill and expertise.
Corporate clients demanded full service banking and full service banking they got. One had to be there to experience the way corporate clients arm-twisted the banks and squeezed them until the pips squeaked. Although bankers have taken most of the flak over the past decade, they were no more than the catalyst in the value chain of capital provision. They were the wizards who could structure transactions which could make borrowers think they were paying less than investors thought they were getting and still take out a fortune in the middle. The smoke and mirror machine was fuelled by too much capital.
Investment banks need to be lean and mean and need to live on their wits. The ”juniorisation” of the industry works when expertise and experience can be replaced with capital. Cut the capital supply to investment banks and things will change. A break-up of the banks will only bring the desired effects if the capital base of the investment banks is limited by a ceiling and not by a floor. At the same time the corporate client world will have to learn not to strong-arm the banks by tying investment banking transactions to loads of cheap loans and near-cost free commercial banking services.
I would take my hat off to Trump if he were to go through with a proper and meaningful separation of capacities but my guess is that this is another bit of orange rhetoric which will go nowhere. Bank stocks dipped quite sharply on the announcement but then they recovered. My guess is that the rebound was driven by the appreciation in the market that whatever the President might have in mind is never going to happen and that the central theme of reduced regulation as in Dodd-Frank remains the favoured outcome.
Back to the day job - bond markets are pricing in an imminent slow-down, stock prices aren’t. They can’t both be right, can they? Why not? If bond’s can’t see early tightening, they can discount out the rate rises they had been pricing in. Stocks, on the other hand, have risen on low discount factors, on the prospect of the cost of money not rising and hence of the interest payments on bonds offering a viable and competitive alternative to dividend streams remaining a distant dream.
Funds have money to invest. Cash, at current rates, is not an alternative and, as I have repeated like a cracked record, no investment manager has a problem with being long in a falling market but he or she will be hung from the yard-arm for being short in a rising one. ETFs and other passive vehicles don’t have either a heart, a brain or a choice. New money flows go straight into the market, irrespective. Being long equities and short bonds is the path of least resistance.
The FOMC meets today and tomorrow – chance of a change in monetary policy plus/minus zero – and Friday brings the April payrolls report. Meanwhile Thursday sees the factory orders and durable goods orders, both strong indicators of whether the president’s rhetoric is effective and whether his envisaged 3%-4% GDP growth is looking like fact or fiction.
Brent is weaker again on the open. We’re at US$51.36 per barrel at the time of writing, less than a dollar above the post-Opec meeting low of US$50.56, which we saw in mid-March. BP reported this morning and with a headline profit number of US$1.51bn it beat forecasts as did its peers that reported last week. Brent had been at US$52.83 at quarter-end although the average price through Q1 had been closer to US$55/bbl. That might have made the numbers look better but if current weakness continues they’ll be giving back a lot of the revaluation gains they’ve reported for the last three months. Keep a close eye on the black stuff; it rarely lies.